A flexible spending account (FSA) is a tax-deferred savings account established by an employer to help employees meet certain medical and dependent-care expenses that are not covered under the employer's insurance plan. Established under Section 125 of the Internal Revenue Code, FSAs were once known as medical Individual Retirement Accounts (IRAs). FSAs allow employees to contribute pre-tax dollars to an account set up by their employer. They can later withdraw these funds tax-free to pay for qualified health insurance premiums, out-of-pocket medical costs, day care provider fees, or private pre-school and kindergarten expenses.
FSAs provide an attractive benefit for many employees, and they also offer tax savings for employers. As a result, FSAs have become very popular with major corporations and small businesses alike. "Employers have struggled for years to offer competitive health benefits to retain and recruit employees while keeping costs under control," Jay Gould wrote in the San Antonio Business Journal. "To solve this problem, an increasing number of employers are implementing Flexible Spending Accounts (FSAs), which allow employers and their employees to save on money set aside for qualifying health and dependent care expenses."
Internal Revenue Service guidelines allow employees to make contributions to employer-sponsored FSAs out of pre-tax income. Thus employees save federal and state income taxes, as well as the employee portion of Social Security taxes, on the amount they authorize their employer to withdraw from their paychecks and place in the FSA each year. By reducing their taxable income, employees can increase their take-home pay. For example, say that an employee of ABC Company whose annual salary was $50,000 contributed $5,000 to an FSA in 2000. This action would reduce the employee's taxable income to $45,000. If the employee typically paid taxes amounting to 30 percent of her income, she would save $1,500 in taxes for 2000. Furthermore, the money contributed to an FSA is not taxable for the employee when it is withdrawn, provided it is used to pay for qualified medical or dependent-care expenses.
Employers also receive a tax benefit by establishing flexible spending accounts. Employers are not required to pay the employer portion of the Social Security tax—which amounts to 7.65 percent of each employee's taxable income—on employee contributions to FSAs. In effect, payroll taxes are reduced by7.65 percent of the total employee contributions to the FSA. In the earlier example, say that ABC Company is a small business with 10 employees and an annual payroll of $500,000. Without the tax advantage of an FSA, the company would owe Social Security taxes of7.65 percent on its total payroll of $500,000, or $38,250, in 2000. But if all 10 employees contributed $5,000 each to FSAs, the company's taxable payroll would be reduced by $50,000, and the company would save $3,825 in taxes for the year. Combined with the tax savings of $1,500 per employee, the total tax reduction for the company and its workers resulting from the FSA would be $18,825 for the year.
It is important to note, however, that employee contributions to an FSA must be used during the year in which they are made. If there is a balance left in an employee's FSA at the end of the year, the employee forfeits that money. According to a study mentioned in the Journal of Accountancy, 91 percent of employers offering FSAs in 1998 reported that forfeitures had occurred. The average amount forfeited was $136 per employee. Since funds cannot accrue in an FSA, it is vital that employers inform employees of the rules and employees estimate their annual expenses accurately.
Employers are required to follow the guidelines established in Section 125 of the Internal Revenue Code when setting up an FSA. The first step, as Gould explained, involves preparing a plan document that states the conditions for eligibility, the benefits provided, and the rules that apply to implementation of the FSA. The employer must distribute these rules to eligible employees and follow them consistently. Employers are also required to file Form 5500 with the U.S. Department of Labor each year, as well as complete a series of nondiscrimination tests outlined by the IRS.
Each part of the process of implementing and administering an FSA plan for employees involves legal requirements. For example, Gould noted that legal requirements apply to the plan document, summary plan description, nondiscrimination testing, government filings, claims administration, and plan updates. Since compliance with these requirements tends to be complex, and since the IRS imposes serious penalties for noncompliance, most companies outsource FSA administration to a third party. Gould claimed that the costs of outsourcing are often offset by the tax savings received by a company.
The administration of flexible spending accounts is also covered under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA). This federal law requires most employers to provide continuing health insurance coverage to employees and their dependents who are no longer eligible for the company's health insurance program. Employees can lose eligibility for coverage by terminating their employment, reducing their working hours, becoming eligible for Medicare, or in a number of other ways. Under the terms of COBRA, all businesses that employ more than twenty people and offer a group health insurance plan must give employees the option of continuing coverage at their own expense for a limited period of time when they lose eligibility for company-provided benefits.
Under the original rules of COBRA, employers were also required to offer participants in FSA programs the opportunity to continue their participation even if they were no longer eligible for the company's health insurance plan. In 1999, however, the IRS introduced additional regulations that changed the treatment of FSAs under COBRA. According to Mark Bogart in the CPA Journal, employers are now obligated to offer FSA continuation coverage only during the plan year in which the employee loses his or her eligibility for benefits. In addition, the new rules established an exception in which employers are not required to offer employees the chance to continue their participation in FSAs at all. The exception applies when the amount the employee could receive from the FSA for the remainder of the year (the amount of the employee's annual contribution, less any deductions already made for qualified expenses) is smaller than the maximum amount the employer could require them to pay to continue their participation in the FSA under COBRA for the remainder of the year (the remaining installments of the employee's annual contribution, plus a 2 percent administrative fee). In other words, employees are entitled to continue their participation in the FSA only if the maximum benefit they could receive is greater than the maximum premium they could be charged under COBRA.
Employers can set up FSAs in a number of ways, depending on what options their employees would find most valuable. For example, FSAs can cover only health insurance premiums, or they can only be used to reimburse medical expenses not otherwise covered by the employer's health insurance plan. FSAs can also cover only dependent care expenses, or they can offer a full plate of benefits including both health care and dependent care.
Dependent care reimbursement FSAs have become increasingly common in recent years. Employees with children can use these accounts to cover day care and educational expenses up to and including private kindergarten. According to a survey conducted by the National Association of Independent Schools (NAIS) and reported in Black Enterprise, 11 percent of the over 52 million school-age children in the United States were enrolled in private schools as of 1999. The working parents of many of these children were able to use pre-tax dollars to pay tuition under an employer's FSA plan.
With a dependent care FSA, employees can begin making pre-tax contributions when a child is born and continue until the child completes kindergarten. The maximum contribution is $5,000 annually per child. The employee decides how much to contribute based on their anticipated child care expenses for each year. The employer deducts that amount in installments from the employee's gross pay each pay period, and sets the money aside in an FSA. The employee's income taxes are calculated based on their remaining pay, which reduces their taxable income. The employee can withdraw money from the FSA tax-free to make tuition payments. In most cases, employees are required to submit proof that their deductions are put toward qualifying dependent care expenses.
Bogart, Mark. "New COBRA Regulations Issued." CPA Journal. June 1999.
"FSAs: Premium Reimbursements, Election Changes When New Benefit Added." Employee Benefit Plan Review. February 1996.
Gould, Jay. "Flexible Spending Accounts Benefit Both Employees, Employers." San Antonio Business Journal. November 24, 2000.
"How Tax Savings Play Out." Inc. March 2000.
Jones, Joyce. "Not Just Kid Stuff." Black Enterprise. September 1999.
"Let's Be Flexible." Journal of Accountancy. March 1998.
Levy, Joel F., and Abba Z. Krebs. "Flexible Spending Accounts: Tax Effective Benefits." Internal Auditing. Summer 1994.
SEE ALSO: Child Care
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